High Frequency Traders May Be Next On The Chopping Block

Will yesterday’s FBI raids on three hedge funds amount to anything? Based on the WSJ story this past weekend, it appears the FBI is looking into how information is being obtained by investors. According to the WSJ, “One focus of the criminal investigation is examining whether nonpublic information was passed along by independent analysts and consultants who work for companies that provide “expert network” services to hedge funds and mutual funds. These companies set up meetings and calls with current and former managers from hundreds of companies for traders seeking an investing edge.” Some say that this is the new way of doing research and that there really is no story here. Others say that if information is not fully disclosed to all market participants, then it is inside information. Here is how the SEC defines inside information:

“Illegal insider trading refers generally to buying or selling a security, in breach of a fiduciary duty or other relationship of trust and confidence, while in possession of material, nonpublic information about the security….Rule 10b5-1 provides that a person trades on the basis of material nonpublic information if a trader is “aware” of the material nonpublic information when making the purchase or sale. ” http://www.sec.gov/answers/insider.htm

We believe that there are similarities between this insider trading case and some parts of HFT, namely:

1) Private Data Feeds – Exchanges make their private data feeds available to everyone. Some exchanges charge for this information, others give it away for free. The data feeds are filled with enhanced trading information. The information that you can receive on these feeds is much greater than what the public sees via the SIP (the securities information processor). Not only can you see orders and trades, but the private data feeds also supply information on revisions and cancellations. Also, they supply order id numbers which can be used to trace the life of an order. This may sound like trivial information but armed with this information, as well as a colocated computer, the advantages of the HFT become great.

2) Flash Orders – Almost 18 months after the controversy, flash (or step up) orders have still not been banned. If you recall, a flash order is an order that is “flashed” to a subset of market participants for up to 500 milliseconds. Market participants who see these orders have the option to take the other side of the trade. They also have a few more options: they could trade in front of the flash order or they could cancel their displayed liquidity before the flash order interacts with it. The reason Flash is still not banned, after nearly 18 months is vast and intense lobbying efforts (remember the Bachus/ Ensarling letter?)We believe that if the FBI and SEC feel that information that investors are getting from some “expert networks” is defined as inside information, then a case can be made that the data that the exchanges are providing could also be considered an “expert network”. The question becomes is the information that the exchanges provide in their private data feeds considered “material, non-public information”? It is certainly not widely disseminated but is it non-public information? We realise that anybody can subscribe to the data feeds and this is most likely the defence the exchanges will use. But is it realistic for most investors to subscribe to these data feeds and then establish the computing capacity to analyse this information. The fact of the matter is not all investors are looking at the same information. Whether this is technically inside information is not for us to decide. But there are two simple ways to level the playing field: 1) Private data feeds should only contain information that can be seen by the general public via the SIP and 2) flash orders should finally be banned.

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